Guest Interview:

Mastrapasqua Asset Management

814 Church Street
Nashville,TN 37203

Interview Quarter: 4Q1997

Frank Mastrapasqua

Chairman & CEO

Q: Your firm's name has been described as "Once learned, never forgotten". What is its origin?

A: "Mas-tra-pas-qua" is my Italian family name which means "Master of Easter". My father immigrated to the United States at the age of 13; devoted his entire career to successful entrepreneurial endeavors in Brooklyn, NY; raised his family on the building blocks of love, education, and hard work; is presently happily retired in his "native" Brooklyn surroundings; and continues to invest in growth companies at the age of 83. It is true, we take great pride in using the Mastrapasqua name since it can only be recalled from "learned memory" and, once imbedded in that module, is seldom forgotten.

Q: How do you define your objectives as a growth manager?

A: Our objective is to build client wealth by acquiring high quality growth stocks at reasonable or value prices on a risk-adjusted basis. We do this by making active sector as well as security selections. There is no capitalization bias, and particular emphasis is placed on 3-to-5 year annual earnings and cash flow estimates. Not surprisingly annual portfolio turnover is relatively low, customarily in the 20% to 25% range. We are particularly sensitive to producing growth without subjecting the portfolio to unnecessary risk. In 1995 we were delighted to report a 42.5% increase compared to the S&P 500 gain of 37.5%. Any one would be happy with this performance, but we realized this performance with a substantial under-weighting in the technology sector which led the overall market in 1995. Since technology has an above-average risk profile, our performance was even more compelling on a risk-adjusted basis.

Q: How does macroeconomics influence your investment methodology?

A: We strive to understand the nature of the existing market and the current economic cycle in order to assess the risk factors we wish to avoid. Primary focus is placed on ascertaining the level of liquidity in the economy and determining if such liquidity is excessive, normal or deficient to support the current pace of economic activity and the level of valuations present in the financial markets. In the 1987 time-frame it became apparent as the year unfolded that a divergence between the equity and bond markets was not sustainable. Either the bond market was going to rally sharply, and/or the equity market would have to adjust downward. As this pressure built, we used our macroeconomic perspective to conclude that the chances were greater for a fall in equity prices. Accordingly, cash was being built from the Spring through the Fall months. After the equity market declined, the Federal Reserve reacted vigorously to stimulate liquidity in the financial system. Consequently, we were favorably positioned to take advantage of our recently accumulated large cash position and confidently committed cash into a depressed equity market. You may recall that at the time most market observers were reticent to make commitments and had no appetite for bullish sentiment.

In 1997, the economy enjoys the combined benefits of solid underlying demand with adequate liquidity. Although the percentage of publicly-held companies participating in the rally remains relatively low (keeping pace with the broad market averages and indexes) and although near term shortfalls from earnings per share expectations are greeted by the markets with unmerciful and emotional selling, the tone of the overall markets is positive. Sustainable economic growth, technology and communication driven productivity, financial liquidity, bond/equity compatibility, and the absence of excess spending or investing are all fundamentally supporting the bullish market sentiment.

Q: How do you use macroeconomics to determine the most attractive market sectors?

A: The monetary and economic forces that are driving business activity and the policy parameters that frame the business climate influence the degree of risk that a portfolio will experience - proactive, defensive, etc. We develop an understanding as to where the economy is in relation to the general economic cycle - accelerating growth, slowing growth, peak, initial downturn, mature downturn, bottom. Once determined, we fit the growth characteristics of particular sectors and companies into the overall economic framework that we have established.

For example, few would challenge the assertion that the US is in the latter stages of an historically extended expansion period. Whether the economic expansion will last another six months, 2 years, or 4 years, we are positioning our portfolios in such a way as to grow but simultaneously build up participation in sectors which have stable and defensive characteristics. Relating to the current environment, this means major emphasis on healthcare and energy stocks. Technology continues to be important, but only in those companies where P/E's are sharply discounted from projected earnings growth rates on a risk-adjusted basis.

Q: How do you weight the effect of any one macroeconomic factor on either the market as a whole or on any given stock?

A: Generally speaking, the normal flow of economic statistics are viewed within the context of the longer term economic environment and not in the same short term focus of most market participants. There are two primary reasons:

First, our economy is fundamentally healthy with considerable growth momentum. As it approaches $8 trillion in size it would take a very unusual set of economic circumstances to cause a sudden shift in fortune. The analogy of turning a huge ship at sea and the significant time and distance required for such a maneuver is appropriate.

Second, it should always be remembered that virtually all economic statistics are subject to adjustment as more accurate testing data is received and greater analytical scrutiny is applied. Over time, initially reported numbers are frequently substantially revised. This fact alone should caution the user from attaching too much significance to the news accounts that capture the nightly headlines or cause immediate swings in major markets. We give primary attention to employment data, monetary aggregates, measures of inflation, other policy variables, and the interrelationship between the equity and bond markets.

These variables tell a story as to the capability of the economy growing, relative to the availability of adequate liquidity. We pay a great deal of attention to the continual unfolding of this story.

Q: Once a sector is identified, how do you narrow down your investment choices?

A: We have a proprietary screen that enables us to prioritize company candidates by size, growth, quality, relative valuations, and fundamental risk factors. We, then, research each company prospect by contacting the company, reviewing Wall Street research, and setting up our own financial spreadsheets and earnings/cash flow models. Our approach is geared toward finding situations where Wall Street has overlooked strong underlying long-term fundamentals or overreacted to a short term concern. We consistently find that institutional preoccupation with quarterly earnings, near term news events, and quarterly performance gives us considerable valuation opportunities as we view portfolio performance within a longer context. Institutional quarterly "window-dressing," and impossible near term institutional performance targets, provide fertile soil from which the more patient investor can prosper.

Q: Please explain what is being measured in the five year growth rate of a stock relative to its P/E. How does this impact the price of a stock?

A: M&A views the P/E as an important valuation benchmark, particularly with growth stocks. The market multiple today is approximately 20 times earnings and most forecasters assume five-year corporate earnings may grow 7 to 10 percent per year. We, in turn, gain considerable comfort in finding quality companies trading at a risk-adjusted P/E below their projected earnings growth rates. Therefore, the market is giving us an opportunity to buy growth in selected issues at value prices, thereby providing us with a margin of comfort that otherwise would not exist (i.e. increasing the likelihood of outperforming the market in both directions). This strategy often prevents us from participating in the most popular growth stocks (i.e. Netscape and Microsoft). However, the benefits of our strategy are realized in the lower risk profile of the portfolio.

Q: How do you weight the importance of the various factors you consider important to the valuation of a stock?

A: The dominant issues are projected 5-year annual earnings and cash flow growth, competitive advantage, and management. All three factors have approximately the same weighting. We independently derive a 5-year earnings forecast working from the primary components of revenue and margins. Back-testing is done through the internal sustainable growth rate components, financing flexibility or inflexibility, and intangibles such as management demonstrated capabilities and consistency in attaining goals. For example, in 1994, Boeing was in an earnings tailspin and the domestic airline industry had completed three years of accumulated red ink that exceeded all combined profits realized since World War II. However, we determined international order rates had started to rise, the delivery of the new B-777 was only 18 months off, and within five years earnings would probably increase from $2.50 per share to $10.00 per share.

The product or service must bear the burden of proving, or demonstrating to us, a competitive advantage that can withstand a broad spectrum of challenges. For example, a small, untried software company would bear a difficult burden demonstrating to us that someone unknown to us is not working on the final stages of building a competitive software that has enhanced capability.

Finally, management is everything. Vision, execution, and problem-solving characteristics must be easily detected, not blurry and obscure. For example, Smart Modular Technologies has well defined competitive advantages. Management builds on these strengths, and, while obvious to the objective observer, the marketplace frequently misunderstands the fundamental nature of this particular business. The attentive investor then gains significant buying opportunities.

Q :What kind of a sell discipline do you use?

A: We never attempt to predetermine a price target and react to that threshold when it is reached. Instead, all portfolio companies are subjected to constant scrutiny. Should the fundamentals deteriorate this could trigger an exit point. As the fundamentals get stronger, the justification for holding and even buying at higher prices becomes more compelling. One must remember that most portfolio performance is driven by only a percentage of the holdings. The winners, therefore, become disproportionately important especially when they double two or three times. Presetting a sell target and holding to that discipline usually translates into mediocre performance over time since the tendency is to prematurely sell the big winners.

Q: What is your investment background and how did you get into investment management?

A: I earned my Ph.D. at New York University studying the effect of economic liquidity on economic and financial market cycles. I, then, became a key economic advisor to the American General group of mutual funds and was the chief investment spokesperson at Faulkner Dawkins and Sullivan and L.F. Rothschild, Unterberg, Towbin. In 1981, I became Chief Strategist and Director of Fixed Income at Smith Barney before becoming Director of Equity Research at J.C. Bradford & Co. in 1986.

Tad Trantum's investment acumen was nurtured in his youth by his father, a long time portfolio manager at a predecessor company to the American Funds. Dinner conversation focused more on investments than any other topic. After obtaining his MBA at New York University and completing an Army tour, Tad became a security analyst at H.C. Wainwright & Co., as well as L.F. Rothschild, Unterberg, Towbin. In 1979, Tad was appointed by President Carter to the Interstate Commerce Commission. Following the deregulation of the trucking industry, he was an investment banker at Rothschild, CEO of a railroad, and the senior analyst at J.C. Bradford & Co.

Q: Do you have any investment mentors?

A: We have a great deal of respect for the capital markets and the challenge they present. Any manager who shares in our respect for the markets, does his/her fundamental analysis, is disciplined toward the longer-term financial perspective, and seeks to buy growth at value prices is a mentor of ours. Surprisingly, there are not too many around! You must believe you can consistently beat the market.

Q: What is it about your particular approach which gives it added value?

A: There will undoubtedly be times when we underperform; however, we impose no artificial restrictions on our investment style that would give us an excuse to underperform due to an under-performing segment of the market. Our confidence in providing value-added management stems from having a combination of skills, experience, and discipline that is usually found only in much larger firms managing multi-billions of asset dollars. Tad and I blend the top-down with the bottom-up approaches; are aggressively inquisitive with respect to their own and other fundamental assumptions; are able to disengage from Wall Street fads, and have the market experience to make the tough decisions necessary to achieve above average performance.

For example, in early 1993, it became clear that the White House was making healthcare a high administration priority with uncertain outcomes. Based solely on the obvious inability to predict outcomes, we virtually exited from all healthcare-related stocks. A year-and-a-half later it had become clear that the White House led "controlling-agenda" initiative was going nowhere. With the stocks at or near historical lows we began a concerted effort to build up our healthcare participation starting in mid-1994. Today healthcare represents our single largest sector holding at about 28%. We strongly believe that sector selection is as important to long term performance as is individual security selection. We also have current overweightings in the technology and energy areas.

Q: Where does your research come from and how do you apply it?

A: Research ideas come from experience, an extensive network of individual investment professionals and businessmen, research-oriented sell-side firms, conferences, and the financial press. The research that leads to a portfolio holding is done in-house using our own company and spread-sheet analysis. The most important aspect involved in the "idea" generating area is to keep an open and inquisitive mind and to be willing to rethink previous assumptions and conclusions. The search for new ideas as well as the constant portfolio reevaluation is a most difficult skill because it requires keeping your personal ego "in check" and maintaining a high degree of respect for the complexity of the capital markets.

Q: How do you achieve high return without increasing investment risk?

A: Our returns will be largely dictated by the direction of the overall market. While we do strive to outperform the market as measured by the S&P 500, we never select high return security prospects without regard to an assessment of the risk profile. A primary benchmark of risk is the price-to-earnings ratio since the market itself builds a risk adjustment into the valuation of any security. Secondarily, past and projected variations of earnings and cash flow per share trends is also a revealing window into risk assessment.

One must always remember that individual sectors and securities differ widely with respect to the predictability of future events that impact financial results. Moreover, even chief executive and chief financial officers with access to all inside information have a wide range of estimating prowess depending on the industry and the competitive dynamics inherent in the individual company. We must therefore make judgments on the predictability of future financial performance, assess what the market expectation is, and determine those situations which have the greatest likelihood where the current market valuation does not adequately reflect the fundamentals inherent in the industry and the company.

This strategy provides our clients with an opportunity to invest in a quality company and, over an 18 to 36 month time-frame, to watch the market catch up to what we believe to be the more compelling and accurate valuation assessment. Our entire investment approach is to buy expected future earnings and cash flow growth at discounted prices as reflected by the risk-adjusted P/E.

Q: In addition to the two principals in the firm who else is part of M&A?

A: The two principals are Tad Trantum and myself. We also have a full time complement of office talent including a securities analyst, trader, and operations/financial individual. In the marketing and client servicing areas we have two individuals introducing our services to high net worth individuals and institutions; a full time person servicing existing clients; and a part-time professional, marketing to consultants and large pension accounts. We believe we have the people and infrastructure in place to substantially build assets from current levels. Our goal is to continue to grow so long as we do not compromise on our investment style and the service level we provide to existing clients.

Q: Is there an upper limit to the amount of money you can manage using your present technique before liquidity becomes a problem?

A: Practically speaking, with $350 million currently under management we have quite a ways to go before liquidity would become a constraint. Our style is to buy growth at value prices without regard to company capitalization. Over time, we find that the best values are found up and down the size spectrum. This gives us much more breathing room than small cap managers when it comes to potential liquidity problems.

A: We do not attempt to "time" the market. We realize that markets can be overvalued for long periods of time and undervalued for long periods. Moving in and out is seldom practical or profitable. Asset allocation is another matter. In a long term sense, if we determined that the economy is coming to a revaluation crossroads, we would raise cash to be positioned to take advantage of opportunities like the 1987 experience. This type of positioning, however, is done on a modest scale and very selectively.

Q: How have you performed in weak markets?

A: In 1990 the market was off 3% and we were up 6%. In 1994 the market was up 1% and we were up almost 3%. What kind of investor might be most attracted to your investment style? Typically we find that financially sophisticated high net worth individuals and financially sophisticated institutions identify quickly with our investment style. We have the best relationships with those clients who, first, buy into our approach and, then, evaluate our performance.

Q; How is your performance derived?

A: We have a representative composite index that is made up of live accounts where we have sole discretion. We report these results in conformance with the Association of Investment Management and Research (AIMR) guidelines. You are only three years old but have $350 million under management. How have you been able to grow so quickly? Our Firm is research driven, not sales driven. Word-of-mouth, investment style, experience, macro and micro perspectives, and maintaining close contact with our universe of companies are probably the most common explanations we receive from clients.

Q: Would you like to add any final thoughts in closing?

A: It is imperative that our clients fully understand our investment style and process. Above all, they must attain a comfort level by knowing that their money is being handled by experienced managers who are constantly challenging their investment assumptions and doing the homework that results in superior long-term performance.